The Fed's dilemma: Continue cleaning up the last crisis, or prevent a new one?

Neil Irwin, The Washington Post

Published 6:49 pm, Tuesday, October 29, 2013

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The Fed's dilemma: Continue cleaning up the last crisis, or prevent a new one?

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WASHINGTON - The leaders of the Federal Reserve will come from far and wide again this week to sit down at a big mahogany table and decide what to do about the nation's monetary policy.

The answer will almost certainly be: Nothing.

The Fed has been buying $85 billion worth of bonds every month for more than a year. It will probably continue. Short-term interest rates have been near zero for nearly five years. That, too, will continue. Fed leaders have been saying that they expect to keep interest rates near zero until the unemployment rate has fallen to 6.5 percent (and officials have hinted that they expect to wait until it is lower than that).

This is all quite a contrast from when they met just six weeks ago. Then, they were deciding whether to begin tapering the $85 billion in bond purchases, as almost every Wall Street Fed-watcher had expected, and offering the first concrete step toward ending the era of unlimited money printing. It was a close call, but they decided not to taper, concluding that the economic data were tepid enough and the fiscal headwinds facing the economy were powerful enough that it would be better to wait to see how things shake out.

They are surely glad they did. Since then, the government has shut down for 16 days, the nation flirted with a debt default and the jobs picture has grown, er, tepider. The open question is not whether the Fed will taper bond buying this week, and even a December taper would require more evidence than we've seen that "substantial improvement" in the labor market is occurring, to use the preferred Fedspeak. Until the millisecond the no-taper news was announced Sept. 17, people thought the Fed was set to begin pulling back. Now it looks like it could be spring before the central bank pulls the trigger.

Here's how to think about what the Fed has been up to the past few months, a sequence that has discombobulated markets. There has been a long-simmering battle within the central bank over this basic question: Should it still be focused all-out on fixing the economic damage wrought by the last crisis? Or should it worry more about risks building in the financial system that could contribute to a future crisis?

On one side are the worriers: They include outright monetary hawks such as Esther George of the Kansas City Federal Reserve Bank and Richard Fisher of the Dallas Federal Reserve Bank. They include a contingent at the Washington-based board of governors including Jeremy Stein and Jay Powell and former governor Elizabeth Duke, who have voted in favor of the QE3 program, but with some reluctance.

This contingent sees ugly side effects of the Fed's easy-money policies. There is "reaching for yield," in which investors take on inappropriate risks to try to goose their returns. There is a shortage of Treasury bonds, used as ultra-safe collateral for a wide range of transactions. There are possible bubbles in everything from Iowa farmland to Indonesian government bonds.

The other contingent is made up of monetary doves such as Charles Evans, Eric Rosengren and Narayana Kocherlakota of the Chicago, Boston, and Minneapolis Fed banks, respectively. It has included, recently at least, James Bullard of the St. Louis Fed bank, who is particularly exercised about the Fed consistently undershooting its 2 percent inflation target. And it includes Janet Yellen, the president's nominee to succeed Ben Bernanke as chairman.

This contingent sees an economy that isn't gathering any real steam, held back by tightening fiscal policy. It sees too-high unemployment as the paramount problem facing the economy, at a time when inflation is too low. Its job is to try to find ways to address this.

The group may concede that the financial market disruptions that the skeptics point to are worth watching, but doesn't see enough evidence of bubbles or other problems to justify backing away from easing. If investors are plowing into riskier investments, well, that's a big part of the point of QE. (It's called the portfolio balance channel: When the Fed takes Treasury bonds off the market, investors have to plow into riskier assets, driving up the stock and bond markets.)

Bernanke's job as chairman has been to navigate these two competing views, to decide which set of ideas is more compelling and steer the policy committee toward that answer.

In the spring and early summer, it was the hand-wringers who had the upper hand. The economy was doing better and a number of bond markets were looking bubbly. That's when the Fed started signaling that tapering may be nigh.

In late summer and fall, the momentum shifted. Economic data have been mixed to negative. The sell-off in the bond markets took away some of the froth and made prices of bonds look more in line with reasonable forecasts of the future of policy. And there have been slight shifts in personnel. Duke retired at the end of August, and Yellen became the nominee to be the next chairman.

At this week's meeting, the thing to watch for is any hint in the Fed's policy statement of how decisive this shift is. What would it take for the taper to finally be back on? Is one or two good months of jobs data enough? Or as the start date of the Yellen Fed approaches, is this a central bank that is content to keep the money pumping in hopes of getting growth on track?

Wednesday afternoon, we get to scrutinize the subtle language of its policy statement to try to figure out which contingent will have the upper hand.